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Cornell International Law Journal
Volume 28
Issue 2 Spring 1995
Article 3
Public Choice Theory and the Transition Market
Economy in Eastern Europe: Currency
Convertibility and Exchange Rates
Jonathan R. Macey
Enrico Colombatto
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Macey, Jonathan R. and Colombatto, Enrico (1995) "Public Choice Theory and the Transition Market Economy in Eastern Europe:
Currency Convertibility and Exchange Rates," Cornell International Law Journal: Vol. 28: Iss. 2, Article 3.
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JonathanR. Macey *
Enrico Colombatto **
Public Choice Theory and the
Transition Market Economy in Eastern
Europe: Currency Convertibility and
Exchange Rates
Introduction
In 1989, the people of Eastern Europe' revolted against their Communist
governments with the hope of achieving political and economic self-determinism. These countries then faced the important challenge of transforming centrally-planned economies into market economies. This
transition process has been a topic of much debate among economic theorists with little agreement as to which transition measures should be taken
2
or when they should be executed.
Public choice theory provides an analytical framework on which the
nature and timing of the transition process can be better understood.
Public choice theory posits that political decisions are made by politicians
acting rationally in their own self-interest. Politicians will form coalitions
when the potential benefits from legislative preference exceed the costs of
organizing and supporting any given piece of legislation. The transition
process in Eastern Europe is not a result of the uniform application of
macroeconomic theory; rather, it is the result of competing interest
groups acting rationally to further their self-interest.
This Article discusses the theoretical application of public choice theory to the economic changes taking place in the Eastern European countries and demonstrates the accuracy of the public choice theory. Part I
discusses the origins of and dedication to transition in Eastern Europe.
Part II explains the mechanics of economic reform. Specifically, this section examines the two fundamental macroeconomic elements of transition: (1) currency convertibility, and (2) issues that relate to the foreign
* J. DuPratt White Professor of Law and Director, John M. Olin Program in Law
and Economics at Cornell Law School. The authors are especially grateful to Kevin D.
Hartzell, Cornell Law School Class of 1996, for his indispensable assistance.
** Associate Professor of Economics at the University of Turin and Director of the
International Centre for Economic Research in Turin, Italy.
1. Eastern Europe is not a homogenous bloc. Eastern Europe presently consists of
some 30 independent states.
2. See CumENCY CONVERTIBiLrny IN
28 CORNEaL INT'L LJ. 387 (1995)
CENTRAL EUROPE
(John Williamson ed., 1991).
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exchange of domestic currency including the nominal exchange rate and
the real exchange rate. Part III synthesizes public choice theory with the
macroeconomics of transition, and Part IV applies this refined synthesis.
The Article concludes that public choice theory accurately predicts the
shape of the transition process, and that the public choice model of transition has normative value.
I. The Origins of Transition
A.
Centrally Planned Economies
Before the latter half of 1989, most European nations behind the "Iron
Curtain" had centrally-planned economies in which the governments were
responsible for and made all decisions related to the production and distribution of economic resources in the nation.3 Essentially, a government
directed the managers of economic enterprises what to produce, how
much to produce, where to obtain necessary inputs and to whom to send
outputs. In many cases, the centrally-planned economy sought to maximize economies of scale by concentrating the production of any particular
4
good in only one location.
In the Eastern European nations, two types of centrally-planned economy existed before 1989. In one variation, government decision-making
was based largely on the quantity of production, with little regard for any
reforms targeted at increasing overall productive efficiency. 5 Bulgaria and
Romania were examples of such economies. Nations following the other
variation made attempts at limited reform in order to allow some market
economy concepts to guide economic decisions. 6 While these reforms
had some characteristics of a market-based economy, they also retained
significant price and market controls. Examples of the latter type of centrally-planned economy included Poland, Hungary, and the former
7
Czechoslovakia.
Even with limited market reform, both types of centrally-planned
economies were ultimately based on the principles of social ownership of
the means of production and extensive central planning. Application of
these principles led to fixed prices for all raw materials, products, and
services, strict government control of all foreign trade, and completely
undeveloped capital markets. 8 These policies, while essentially eliminating unemployment, also resulted in chronic shortages and misallocations
of all types of economic resources and products.
3. Nigel Healey, The TransitionEconomies of Central and Eastern Europe,29 COLUM. J.
WoRLD Bus. 62, 65 (1994).
4. For example, in the former Soviet Union, it is estimated that 75% of the 6000
main industrial products were manufactured at only one facility. Id. at 66.
5. INES MOROVIC, CURRENCY CONVERTIBILITY AND ECONOMIC TRANSMON IN CEN.
TRAL AND EASTERN EUROPE 14 (1993).
6. Id.
7. See id.
8. See id.
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Public Choice Theory and Currency Convertibility
Both the centrally-planned economy and the individual firm in such
an economy were bound by a "soft" budget constraint. A "soft" budget
constraint is characterized by the absence of a bottom line and by economic decisions made in an environment which did not require that any
budget, at any level in the economy, be balanced. 9 Thus, firms had no
incentive to seek new markets, to develop new products or technologies,
or to do much of anything except meet the government targets.' 0 Workers and resources were employed, not in the most efficient manner, but in
a manner made obligatory by state-supplied directives. Firm behavior was
not guided by any sense of profitability.
Eastern European foreign trade policies were based primarily on the
strategy of "import substitution." Under this approach, governments
implemented a trade policy which would fill gaps in the economy left by
the failures of central planning." The gaps were the result of the socialist
emphasis on heavy industries and an undeveloped service sector in these
countries. Because foreign trade was closely monitored and controlled by
various state agencies, the Eastern European nations were unambiguously
2
autarkic.'
As a result of these policies, currencies in the Eastern European countries did not serve the same basic functions served by currencies in free
market economies. In Eastern Europe, a currency did not function either
as a store of value or as a means of facilitating exchange. Instead, the
socialist governments resorted to printing money in order to fund all activities in the nation. This "soft budget policy" created excessively large
money supplies in these countries and resulted in the rise of a dual currency system, where private transactions were conducted with Western currency. The Eastern European currencies were valueless in foreign markets
as well as in the home country. 13 Furthermore, Eastern European economies were characterized by the complete absence of domestic competition
and of a functioning price system. These currency problems made it
increasingly difficult for any Eastern European nation to participate in
international trade.
The soft budget policies caused hyperinflation throughout most of
9. See id.
10. Id.
11. Id.
12. John Williamson, The Economic Opening of EasternEurope, in CuRFR.NCv CoNVERTI363, 365 (John Williamson ed., 1991).
BiLlTy IN EASTERN EUROPE
13. In the Soviet Union in 1988, only five percent of the domestic interfirm transfers of materials and goods was completed by contract-the other 95% was transferred
on orders from state planning agencies. The domestic currency was worthless because
there was no use for it. Internationally, the ruble wvas equally valueless. For example,
PepsiCo, Inc. invested $3 billion in the former Soviet Union, with the purpose of producing and selling PepsiCo products. The return on PepsiCo's investment was not in
currency: PepsiCo received ten sea-going tankers and freighters and huge shipments of
Stolichnaya vodka. See Reuven Brenner, The Eastern Bloc: Legal Reforms Before Monetary
and MacroeconomicPolicies, in EXcHANGE RATE PoUCIES IN DEVELOPING AND POST-SocIALisr CouNRrmEs 151, 164 (Emil-Maria Claassen ed., 1991).
Cornell InternationalLaw Journal
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Eastern Europe.' 4 Nominal wages rose dramatically, but real wages
declined. 15 Foreign debt also increased, and the absence of foreign trade
allowed for only minimal repayments in hard currencies. Without a monetary means of exchange, centrally-planned economies became based on
barter, both internationally and domestically. These barter-based economies were incapable of meeting even the most rudimentary demands of
their citizens. The political changes in 1989, certainly encouraged by these
economic failures, made possible the transition from planned socialism to
16
a free market economy.
B.
Nascent Dedication to Transition
The new regimes in Eastern Europe generally favored expediting the transition to a market economy. These sentiments were particularly strong in
Central Europe and East Germany. 17 These new governments were willing to run the political risks, inherent in a program of radical economic
reform, in order to secure a rapid economic transformation.' 8 The prevalent belief in the West was that these Central European nations would naturally prefer the type of social market economy that existed in Austria,
West Germany, and Finland. 19 The unification of the East and West Ger20
man economies fulfilled these expectations.
The other Central European nations, such as Poland and Czechoslovakia, opted for a laissez-faire market economy. This preference may be
explained partly by the legacy of socialism in those countries, which produced distaste for anything remotely "social." 21 It also may reflect a concern about the high costs implicit in a social market economy. The
Minister of Finance of the Czech and Slovak Republic explained the preference for a laissez-faire market economy:
The decision to undertake this reform strategy rapidly and in this sequence
was based on two deeply held convictions on the part of the Czechoslovak
reformers. The first was that central planning and a free market cannot
coexist without further destabilizing the already unstable economy. The
second was that, because of the relative economic weakness of the government and the vested interests of government bureaucrats (as postulated by
the arguments of the public choice school), the central authorities do not
have the ability to organize economic life in an appropriate manner or to
2
guide state firms toward rational economic behavior.
14. See MoRovrc, supra note 5, at 15.
15. Id.
16. For a discussion of pre-1989 reforms in Eastern Europe, see Williamson, supra
note 12, at 367-72.
17.
18.
19.
20.
21.
Id. at 373.
Id.
Id.
Id. at 374.
Id.
22. Vaclav Klaus, Price Liberalizationand Currency Convertibility: Twenty Days After, in
CURRENCY CONVERTIBILrrY IN EASTERN EUROPE 9, 11 (John Williamson ed., 1991).
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Public Choice Theory and Currency Convertibility
The Balkan nations, notably Bulgaria and Romania, did not move so
quickly or emphatically to implement a market economy. In 1990, following the peaceful overthrow of the Communist regime in Bulgaria and the
violent removal of the Communist government in Romania, both nations
elected former Communists to power. These new leaders, however,
declared their commitment to a market economy.23 In the year following
the elections, these Balkan nations took decisive actions directed at transition, albeit more slowly than the Central European nations. Yugoslavia's
delay in making an economic transition is likely due to the extensive eth24
nic conflicts in that country.
Despite these differences, the Eastern European nations shared two
fundamental beliefs. First, Eastern Europeans recognized that central
planning does not work, and that markets do.25 Second, they comprehended the importance of the international economy. While economists
in these countries once favored import substitution as the key to economic
development in a relatively autarkic environment, they now favored outward orientation.2 6 Eastern European countries wanted to open their
economies and become integrated with the economies of the West, as well
as those of the rest of the world.2 7 The principle of comparative advantage became one of the basic tools that Eastern European countries used
to achieve economic integration. This theory posits that the goods a
nation can produce relatively more efficiently than the rest of the world
should be produced and exported, while those goods which the country
cannot produce as efficiently should be imported.
More broadly, the goal of each of the Eastern European nations was
to establish a free market environment by dismantling the system of central planning and stabilizing the existing and evolving economy.2 8 Generally, the Central European countries2 9 appeared to be in a better position
to quickly and successfully accomplish transition ° because their governments had implemented some market-oriented reforms under the pre1989 Communist regimes. Other nations in Eastern Europe, which had
31
not previously attempted reform, were not so well-situated.
In all of these nations, however, the reformers sought to achieve economic stabilization through measures such as control of the government
budget deficit, elimination of excess money supply, price reform, foreign
trade, property reform, and general economic restructuring.32 By imple23. The elected governments were comprised of former Communists under different party names: the Socialist Party in Bulgaria, and the National Salvation Front in
Romania. Williamson, supra note 12, at 374.
24. Id.
25. Id. at 375.
26. Id.
27. Id. at 375-76.
28. MoRovic, supra note 5, at 16.
29. Poland, Hungary, and the Czech Republic.
30. MoRovic, supra note 5, at 16.
31. Id.
32. Id. Specific objectives included reduction in inflation rates endemic to the pre1989 Communist regimes, and to increase exports.
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menting these policies, leaders sought to restore confidence in and value
to the domestic currencies.53 Implicit in many of these objectives was the
necessity to "harden" the "soft" budget constraint and to dismantle staterun monopolies.3 4 Currency stabilization and price reforms would allow
participation in international trade and fulfill the long-suppressed need
for various foreign goods, services, and capital. 35 Fundamentally, the goal
of each Eastern European nation was to become a successful and stable
market economy based on the Western model in a relatively short time.3 6
II. The Mechanics of Transition
The reform mechanism which is the subject of the most attention and
debate is currency convertibility. Currency convertibility, generally, is the
freedom to buy and sell foreign exchange with the domestic currency, usually for payments related to the international flow of goods, services, and
capital. Current account convertibility is generally advocated as a source
of domestic competitive discipline and price signals, both of which play a
vital role in guiding domestic firms and individuals toward efficient production, consumption, and investment decisions. Capital account convertibility serves to attract foreign capital investment. Convertibility is often
the centerpiece of the reforms established by Eastern European nations in
transition. As such, it is not only symbolic of new openness and freedom,
but also of the ability of an individual government to implement transition
reforms.
A currency is convertible if it "is freely exchangeable for another currency."3 7 This definition does not imply the right to convert (the domestic currency for foreign currency) at a fixed exchange rate, but rather to
convert at the legal exchange rate.3 8 The general definition of convertibility does not specify who is allowed to exchange the currency freely or
for what purposes. Convertibility is unrestricted if anyone can freely
exchange the domestic currency for any purpose at the legal exchange
33. Id.
34. See id. A hard budget constraint requires a firm or government to balance the
budget. This constraint necessarily involves a complete reconsideration of government
subsidies which are made in order to keep inefficient industries from collapsing.
35. See id. at 16-18.
36. Williamson, supra note 12, at 376. A move to outward orientation of the econ-
omy has also marked Latin America and some Asian countries. Eastern Europe is
unique, however, in the magnitude of its transformation from a planned economy to a
market economy. Where transformation and privatization in other countries has
involved at most 40% of the Gross Domestic Product (GDP), the transition in Eastern
European countries involves over 95% of the GDP. Eastern European nations are
essentially creating market economies from nothing. Id.
37. Id. at 377. Most developed, industrial nations have unrestricted convertibility,
although this is a relatively recent development. France and Italy abolished their
remaining capital controls in 1990. Id.
38. Eastern European countries were characterized by the rise of unofficial markets
where foreign currencies could be exchanged. At the unofficial rate, the domestic cur-
rency was almost always depreciated in comparison with the official rate. Id.
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Public Choice Theory and Currency Convertibility
rate.3 9 Different types of convertibility limit the persons who may
exchange the domestic currency and for what purposes they may
exchange.
A.
Current Account Convertibility
Current account convertibility is the freedom of anyone, specifically
domestic importers, foreign exporters, and investors, to freely exchange
domestic for foreign currency at the legal exchange rate in order to settle
any transaction involving the purchase of foreign goods and services, interest payments, or the repatriation of profits. 40 Current account convertibility is often limited through restrictions on the amount of currency citizens
may take out of the country for tourist expenditures. Some countries further limit current account convertibility by suspending payment of interest
on their foreign debt. 4 1 A nation could further restrict current account
convertibility by intensifying trade restrictions through methods other
than limitations on the exchange of currency. 42 In general, the sum of
currency exchange controls and trade restrictions determine the extent to
which a country's goods and services markets are integrated with the rest
of the world.43
In nations where the economy was centrally-planned, the establishment of current account convertibility, combined with minimally restrictive trade regulations, introduces a new degree of freedom into the
economy. 44 In the absence of quantitative restrictions on imports, the
direct benefits of current account convertibility may include significant
increases in consumption and consumer satisfaction, as well as improvement in the domestic output of goods and services. 45 Improved access to
production inputs and technology constitutes another beneficial effect of
current account convertibility. 4 6 These changes may occur because of the
opportunity to purchase foreign goods and services.
Traditionally, scholars have considered the indirect benefits of current account convertibility more substantial than the direct benefits. Indirectly, current account convertibility creates a more competitive
environment within the country and promotes more efficient production
and investment decisions. 47 The transition to a market economy requires
the decentralization of production and investment decisions. In a market
economy, information provided through market-determined prices coor39. Id.
40. Id.
41. Id.
42. Id.
43. See id.
44. Joshua E. Greene & Peter Isard, Currency Convertibility and the Transformation of
Centrally Planned Economies, in WEALTH CREATION INEASTERN EUROPE: FINANcIAL MANAGEMENT ISSUES AND STRATEIEs 87, 92 (Fred R. Kaen & Ike Mathur eds., 1992).
45. Id. at 93.
46. Id.
47. Much of this improved efficiency is a result of the inevitable requirement that
economic decision-makers consider the country's comparative advantage. Id.
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dinates these decisions; the market's success depends on the quality of this
information and the efficacy of the price-adjustment mechanism in equilibrating supply and demand. 48 Only a competitive, non-autarkic environment can supply the required price information.
Exposure to international competition introduces an economy to prevailing world-market prices. This competition provides domestic producers with a strong incentive to make more efficient decisions and enables
them to produce more. 49 In addition, by opening vast markets, international competition provides domestic producers with an incentive to
expand the production of some goods and services. 50 Competition also
reduces the market power of monopolies and oligopolies, which are common elements of centrally-planned economies. In general, international
competition, the result of current account convertibility and a liberal
trade environment, induces domestic producers to allocate resources in
the most profitable and efficient manner in order to exploit the country's
comparative advantage. The long term result is an improvement in the
quality and quantity of domestic industry. 5 1
These improvements impose certain costs as well. In the short term, a
nation will experience substantial domestic unemployment and idle economic capacity if it abandons domestic goods and services in favor of
imports (adjustment costs).52 Substantial reductions in real wages may be
necessary to ensure that domestically produced goods remain competitive
at home or survive in international markets, especially if the domestic
goods are of a lower quality than goods and services available internationally. The result in both cases is a substantial reduction in domestic
53
income.
B.
Capital Account Convertibility
Capital account convertibility is loosely defined as the freedom to
54
exchange domestic for foreign currency through capital transactions.
Economies in transition require sizable foreign capital investments and
inflows. A significant factor affecting the willingness of foreigners to so
invest is the prospect for repatriation of profits, interest, and investment
principal, as well as the viability of individual projects. 55 Citizens of a transitioning economy with liberal capital account convertibility will also have
48. Id.
49. Id.
50. Eastern European nations with relatively small populations are not large markets in and of themselves. The doctrine of comparative advantage posits that a nation
cannot efficiently produce all the goods and services it requires. This inefficiency is
especially true when the market is small because producers cannot capitalize on economies of scope and scale.
51. Greene & Isard, supra note 44, at 94.
52. Id.
53. Arguably, the effect of this reduction may be overstated because of the low standard of living which generally characterized Eastern Europe before transition.
54. Greene & Isard, supra note 44, at 95.
55. Id.
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Public Choice Themy and Currency Convertibility
the opportunity to invest abroad and perhaps achieve greater returns on
their foreign investment than would be possible through domestic
56
investments.
Foreign capital inflows are particularly important to the success of
economies in transition. Foreign capital can make possible a multitude of
economic developments otherwise impossible for want of domestic capital
investment. Frequently, foreign investors will back their capital investment with support beyond mere funding. 57 As a result, economies in transition will benefit from an influx of technology, management,
management techniques, and marketing information; this array of competitive assistance will increase the international competitiveness of the
domestic economy. 58
Capital inflows on a large scale may cause much greater
macroeconomic turbulence. Significant foreign capital investment may
lead to greater volatility in exchange rates, external reserves, and interest
rates. If most of the capital inflow is in the form of foreign lending, the
transitioning nation may face an excessive debt burden. 59 Capital account
convertibility also creates a risk of domestic capital flight, as capital
resources available from domestic sources are diverted to foreign invest60
ments with greater potential for return on capital.
Generally, capital account convertibility is not an end in itself, but
merely a function of other reforms. Capital account convertibility will not
successfully attract foreign investment unless there is relative certainty and
confidence in the country's current and prospective economic and legal
reforms. 6 1 The inherent instability of transition economies, the tremendous risks of capital flight, and wide exchange rate fluctuations which follow a policy of complete capital account convertibility have led Eastern
European nations to restrict the convertibility of various capital transactions.6 2 Although restrictions on capital flows have become difficult to
enforce as world capital markets become more integrated, the capital flow
effect of creating a dual exchange rate in
restrictions do have the 6notable
3
a transitional economy.
C. The Dual Exchange Rate
In developing countries, the increasing openness of capital markets allows
market forces to play a large role in determining the exchange rate of
56. Id. at 122 n.8.
57. Id. at 95.
58. Id.
59. Id. at 96.
60. Domestic capital flight may also be considered a benefit to citizens. See supra
text accompanying notes 51-53.
61. Green & Isard, supra note 44, at 96.
62. Id. at 97. The Czech Republic is expected to be the first Eastern European
nation with full convertibility (complete current and capital account convertibility), but
not for several years. See Kocarnik Expects Full Convertibility in Two to Three Years, CTK
NATiONAL NEWS WiPE, Feb. 17, 1995, available in NEXIS, News Library, Allwld File.
63. Greene & Isard, supra note 44, at 97.
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major currencies. 6 4 In developing and transitioning nations, the
exchange rate is largely an instrument of policy, set by the government or
monetary authorities. Thus, the exchange rate is not directly influenced
by market forces.6 5 Restrictions on capital account convertibility, universal in the transitioning economies of Eastern Europe, result in a dual
exchange rate system. The dual rate follows from extensive current
account convertibility (with convertibility for some capital transactions)
without corresponding full convertibility for capital transactions. 66 In
practice, different exchange rates prevail for different types of
67
transactions.
There are two aspects of the dual exchange rate system. The first is
the nominal exchange rate, which is set by a declaration of the government. The second is the real exchange rate, which applies to certain mercantile transactions.
1.
The Nominal Exchange Rate
The nominal exchange rate is literally the cost of foreign currency in
terms of domestic currency. This rate is commonly found in newspapers
and other easily accessible sources. It is ostensibly the rate at which any
amount of foreign currency can be exchanged for an equivalent amount
of domestic currency. Of course, this absolute freedom of exchange is
often restricted by various convertibility regimes. For example, the nominal exchange rate may be fixed. In such a case, the government sets the
rate of exchange by declaration. Alternatively, the nominal exchange rate
may be determined in a floating regime in which domestic and international market forces determine the relative value of the domestic currency.
No Eastern European nation has adopted a floating rate regime.
While it is arguably the apogee of a true market economy, governments
have resisted the floating exchange rate for several reasons. One reason is
the difficulty of interpreting the traditional monetary indicators under a
floating regime. Another problem is that a floating rate can only function
efficiently in the presence of a well-developed capital market. 68 The final
explanation for the reluctance to implement such a regime is that floating
rates have a propensity to induce large trade imbalances and consequent
69
economic distortions even in large and well-developed economies.
Economies in transition lack both the expertise to resolve the first problem and the required capital market infrastructure to accomodate a float64. Bijan B. Aghevli & PeterJ. Montiel, Exchange Rate Policiesin Developing Countries,
in EXCHANGE RATE PoLicIEs IN DEVELOPING AND Posr-SocAmuST CouNTmuS 205 (Emil-
Maria Claassen ed., 1991).
65. Id.
66. Greene & Isard, supra note 44, at 97.
67. Different exchange rates may apply to different types and quantities of imports,
as well as to private debt service, profit repatriations, and other varieties of capital remittance. See Aghevli & Montiel, supranote 64, at 206.
68. Id. at 393-94.
69. Id. at 394.
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Public Choice Theory and Currency Convertibility
ing rate regime. In addition, the final concern about distortions would
only be magnified in Eastern Europe's infant market economies.
Each of the Eastern European economies in transition has adopted a
fixed exchange rate. These countries may utilize a multitude of methods
and policies to fix the rate.70 However, all fixed rate regimes have several
principles in common, including the willingness to interfere with capital
and current account markets in order to maintain the fixed rate. If the
exchange rate was determined by market forces, then it would not be
fixed, but floating. Therefore, in order to maintain a fixed exchange rate,
a government must adjust its economic policies to respond to changing
market conditions.
There are two major requirements for the successful maintenance of
a fixed exchange rate. The first is a willingness to restrict capital account
convertibility. If capital mobility were unrestricted, it would be virtually
impossible to maintain the fixed rate. 71 Second, a fixed exchange rate
requires a willingness to allow the money supply to be determined by the
balance of payments. 72 The government must be prepared to interfere
with the balance of trade-through, for instance, protectionist intervention-in order to maintain the money supply. The stability and efficacy of
the fixed exchange rate, as perceived by international markets, depends in
large part upon the credibility of the government. Investors must believe
that the government can and will undertake the measures necessary to
maintain a fixed exchange rate.78
Government credibility forms the basis for the major objections to the
fixed exchange rate. If an economy is in transition, investors may have
little faith in the government's ability to determine the proper fixed
exchange rate. 74 Eastern European governments, with their socialist legacy, may also lack the political capability or the willingness to undertake
the austere economic measures which are sometimes necessary to maintain a fixed rate.
2.
The Real Exchange Rate
The real exchange rate is an endogenous macroeconomic variable and
75
It is a function of the
cannot be directly controlled by the authorities.
relative prices of internationally traded goods, adjusted by the nominal
70. For a detailed discussion of these methods and their respective merits, see
EXCHANGE RATE PouciEs IN DEVELOPING AND POST-SocAusr CouNTiuEs (Emil-Maria
Claassen ed., 1991).
71. See Aghevli & Montiel, supra note 64, at 228-32.
72. Growth in the domestic money supply can result from an increase in government expenditures. If these expenditures are not restrained, inflation and a relative
devaluation of the domestic currency will result. If the fixed rate is not adjusted to
compensate for this growth in the money supply, the exchange rate will not be useful to
markets as an indicator of relative prices. Parallel currency markets and alternate
mechanisms for the store and exchange of value will arise. See Williamson, supra note
12, at 394-95.
73. Id.
74. Id. at 394.
75. Aghevli & Montiel, supranote 64, at 227.
Cornell InternationalLaw Journal
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exchange rate. 76 An economy in transition produces or uses three types
of goods: importables, exportables, and nontradables. 7 7 The prices of
both imports and exports are set on the world market. Domestic consumers must pay a price for imported goods set by the foreign producer, and
the international market determines the price for exports. Various supply
and demand conditions within the country determine the price for nontradables. The real exchange rate is the relative price of nontradable
goods to tradable goods. 78
In general, if the real exchange rate is weak, the domestic price of
tradables is relatively lower than the price of nontradables. Conversely, if
the real exchange rate is strong, then the relative price of tradables is
higher than the price of nontradables. Where the real exchange rate is in
equilibrium, the domestic market for both tradables and nontradables
clears. In this case, the production capacity of the country in transition is
utilized most efficiently, and there is no excess supply or demand for any
tradable or nontradable good.
If the domestic economy is not current account convertible, variations
in the real exchange rate are generally inconsequential. 7 9 However, if the
domestic economy has implemented a policy of current account convertibility, disequilibrium in the real exchange rate leads to domestic economic
turbulence. A simple example is illustrative.
An economy produces and consumes three goods: exports, imports
and nontradables. Initially, the domestic price for each good is 5 DUs
(Domestic Units). The price for each tradable good on the international
market is 1 FU (Foreign Unit). The relative price of nontradable goods to
tradable goods is 5:1. If the real exchange rate is devalued to 7:1, the
relative prices change. The nontradable good price remains 5 DUs. However, while an export is still worth only 1 FU on the world market, the
price received by the domestic producer of an export is 7 DUs. Imports
also cost 7 DUs. If the real exchange rate is overvalued, the real exchange
rate is 3:1. The nontradable still costs 5 DUs. The amount received by the
domestic producer of an export is only 3 DUs, while an import also costs 3
DUs. Both the export and the import are still valued in the world market
at 1 FU.
Generally, when the real exchange rate is weak (7:1 in the example),
there will be an excess supply of exports in the domestic market. The
reason for this surplus is that exporters receive relatively more in domestic
currency for exports than they would if they produced nontradable goods
or goods which could be imported. Domestic consumers will prefer non76. Id. at 212.
77. Exports and imports combined are "tradables."
78. Deepak Lal, Growth Collapses, Real Exchange Rate Misalignments and Exchange Rate
Policy in Developing Countries, in EXCHANGE RATE PouciEs IN DEVELOPING AND POSTSocIALusT CotmuNrs 277, 286 (Emil-Maria Claassen ed., 1991).
79. This is because a nation without current account convertibility is essentially
autarkic, and not dependent on world markets to satisfy economic needs. However, it is
well-accepted that the autarkic, centrally-planned economy is unacceptable. This belief
constitutes much of the basis for the transition to market economies in Eastern Europe.
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Public Choice Theory and Currency Convertibility
tradable goods over imports, because, assuming that there is no difference
in quality, nontradables are less expensive. The excess supply in the
domestic market of exports will be consumed by the world market. With a
weak real exchange rate, the country will have a foreign trade surplus.
There will be a net increase in domestic productivity because not only will
there be an increase in export production, but domestic consumers will
also prefer nontradables over imports. This preference reduces net
imports and expands the domestic market for and production of nontradables.8 0 A weak exchange rate may also impose inflationary pressures on
the domestic economy as increased foreign trade and the expansion in
domestic output accelerate the demand for money.
When the real exchange rate is strong (3:1 in the example), the result
will be a net reduction in output of the domestic economy. Producers will
have an incentive to shift productive resources to the manufacture of nontradables, since their return on the production of exports is only 3 DUs,
whereas the return on nontradables is 5 DUs. There will be an excess
supply of nontradables because of producer conversion and reduced consumer demand. The net effect on the economy will be increased unemployment because the world market cannot absorb the excess supply of
nontradables. Another potential effect is a trade deficit, which is produced by consumer preference for imports and the reduction in export
production. However, the economy can benefit from the near elimination
of inflation, since there will be a decrease in demand for the domestic
81
currency.
Public Choice Theory and Transition
I.
There is widespread agreement that the Eastern European countries will
82
accomplish the transition to market economies. There is equal agreement that the method of achieving this transition is through current
account convertibility and, eventually, capital account convertibility. However, while there is substantial agreement as to what will be eventually
over how the
achieved, there is considerable theoretical disagreement
83
proceed.
should
economy
market
a
to
transition
Although economists cannot reach consensus as to the ideal theoretical transition policy, the actual policies implemented by Eastern European
nations in transition have both remarkable similarities and significant differences. However, the theoretical debate about transition theory lacks a
fundamental understanding of the process by which governments reach
decisions. Public choice theory provides economists with a decision-making model. Vaclav Klaus was only partially correct when he averred that
bureaucrats in a centrally-planned economy could not make the decisions
80.
81.
82.
83.
See Aghevli & Montiel, supranote 64, at 225-26.
See id.
MoRovic, supra note 5, at 1.
Id.
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necessary to guide the entire economy. 84 In fact, self-motivated bureaucratic behavior is not confined to centrally-planned economies. While no
government can successfully manage every aspect of any economy, public
choice theory explains why politicians decide as they do.
A.
Public Choice Theory
The economic (or "interest group") theory of legislation "asserts that legislation is a good demanded and supplied much as other goods, so that
legislative protection flows to those groups that derive the greatest value
from it, regardless of overall social welfare." 85 Under this theory, decisions made by politicians, bureaucrats, and political coalitions are analyzed according to generally accepted principles of rational economic
behavior. The economic theory of regulation predicts different outcomes
than the traditional "public interest" theory of regulation, which posits
that regulation is designed to benefit the public by solving collective
action problems and other sorts of market failure. 86 In contrast, the economic theory of regulation treats the behavior of political decision-makers
just like that of their private-sector counterparts: they attempt to maximize their own self-interest, often at the expense of overall societal
welfare.
Under the economic theory of regulation, interested parties form distributional coalitions in order to trade resources, such as power, influence,
and money, in exchange for legislation that provides benefits to the coalition members. An effective distributional coalition will form when the
benefits from effecting wealth transfers through the political vehicle outweigh the costs of organizing. Some groups will be able to organize into
distributional coalitions more cheaply than others. 8 7 Groups that have
already formed into coalitions for exogenous reasons, such as mutual professional organizations or unions, will find that the marginal costs of
diverting their activities to the political arena are far outweighed by the
benefits such activities can procure from favorable legislation and govern88
mental policy.
The economic theory of regulation recognizes that organized distributional coalitions are better able to provide the support politicians
require to retain office and status than are disorganized citizens. Accord84. See Klaus, supra note 22, at 11.
85. Richard A. Posner, Economics, Politics, and the Reading of Statutes and the Constitution, 49 U. CHI. L. REv. 263, 265 (1982).
86. ROBERT E. MCCORMICK & ROBERT D. ToLLISON, POLITICIANS, LEGISLATION, AND
THE ECONOMY.
AN INQUIRY INTO THE INTEREST-GROUP THEORY OF GOVERNMENT
3
(1981). The relatively naive view that legislators are public-regarding guardian angels
who meet periodically to right the wrongs of society has been thoroughly discredited.
SeeJoseph P. Kalt & Mark A. Zupan, Capture and Ideology in the Economic Theory of Politics,
74 Am.ECON. REv. 279, 279 (1984).
87. McCORmicK & TOLuSON, supra note 86, at 16-18; MANCUR OLSON, THE RISE AND
DECLINE OF NATIONS:
ECONOMIC GROWTH, STAGFLATION AND SOCIAL RIGIDITIES
18
(1982).
88. SeeJonathan R. Macey, Transaction Costs and the Normative Elements of the Public
Choice Model: An Application to ConstitutionalTheory, 74 VA. L. Rzv. 471, 477-80 (1988).
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Public Choice Theory and Currency Convertibility
ingly, politicians unable or unwilling to satisfy distributional coalitions will
be driven from office by rival politicians more capable or willing to supply
the demands of the distributional coalitions. For example, suppose a particular piece of legislation will cost citizens $3.00 each in new taxes, but
will transfer $200 million to a particular distributional coalition. In order
to oppose the legislation, the public will face costs of organization which
will likely exceed the per capita tax increase of $3.00. Furthermore, citizens must also expend resources to acquire information about the merits
of the proposed legislation. This information cost per citizen will also
exceed the individual tax burden. It is only rational that citizens not
expend resources to acquire information beyond the per capita cost of the
legislation or organize to oppose the legislation. Citizens will instead
remain ignorant about the effects of the proposed wealth transfer and will
not organize to resist it. The distributional coalition, however, has every
incentive to expend resources up to the full amount of the proposed
wealth transfer in order to effectuate the legislation and the wealth
transfer.
A useful generalization, while not without some qualification, is that
the economic theory of regulation predicts that legislation will typically
grant concentrated benefits to discrete groups funded by widely dispersed
costs. This result will occur because the cost of legislation is borne by the
disaggregated public, who are in the worst position to object to it. The
distributional coalitions, however, are able to successfully trade political
support for the passage of wealth-transferring legislation. Politicians have
strong incentives, notably the desire to gain office or to retain it, to seek
out issues where the winners-the distributional coalitions-are easily
identified and where the losers-those from whom wealth is extractedare difficult to identify.8 9 Such issues concentrate the benefits available to
the distributional coalition, readily enabling their support, while
camouflaging (and increasing organizational and information costs for)
those who must pay for the coalition's benefits with higher taxes,
increased regulatory burdens, and higher prices for goods and services.
Another aspect of the economic theory of regulation is "rent extraction." This process is distinguishable from "rent creation," by which a distributional coalition arises to support legislation which favors the coalition
at the expense of the disaggregated public or rival producers. "Rent
extraction" occurs where economic actors in markets which appear to be
operating relatively free from government regulation must expend
resources to keep their markets unregulated. 90 Politicians may then
extract rent from economic actors in certain markets in exchange for their
regulatory forbearance.
According to the economic theory of regulation, the economic and
monetary policies of a nation in transition to a market economy reflect the
89. Jonathan R. Macey, PromotingPublic-RegardingLegislation Through Statutory Interpretation: An Interest Group Model 86 COLUM. L. Rxv. 223, 229-30 (1986).
90. Macey, supra note 88, at 479; see Fred S. McChesney, Rent Extraction and Rent
Creation in the Economic Theory of Regulation, 16J. LEGAL STUD. 101, 102-03 (1987).
Cornell InternationalLaw Journal
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actions of rational and self-interested political and economic actors. For
instance, if the transition process is generally successful, distributional
coalitions will seek out and support new wealth-transferring policies made
possible by the economic transition. Alternatively, coalitions faced with
the loss of wealth-transferring legislation because of a successful transition
will pay politicians to oppose legislation which alters the status quo.
Regardless of the status of the transition process, politicians will attempt to
identify and capitalize upon particular issues where the benefits are concentrated and the costs diffused. An especially powerful consideration for
both politicians and the distributional coalitions is the magnitude of possible effects of the wealth-transferring legislation, in the form of monetary
policy, on the welfare of the citizenry as a whole. While a wealth transfer
to a distributional coalition funded by a disaggregated tax increase may
impose relatively small costs on individual citizens, a nation's monetary
policy, exchanged by the politician for support from a distributional coalition, may dramatically increase costs to individuals. In such a case, the
costs to the individual of obtaining information about the policy and
organizing to oppose it may be less, perhaps even significantly less, than
the per capita cost of the legislation. Because of these increased costs,
previously uninformed citizens and individual opponents to the legislation
will coalesce into effective distributional coalitions to oppose the
legislation.
B.
Public Choice Theory and Convertibility
A policy of full convertibility, where the government of a nation permits its
citizens to purchase unlimited amounts of foreign currency and other
assets with domestic currency in both the exchange of goods and services
and in capital transactions, may have either beneficial or destabilizing
effects on the national economy. These effects depend on a nation's pretransition capability in the tradable goods sector and its consequent ability
to maximize the positive economic results of full convertibility and a market economy through comparative advantage.
Before transition, the tradable goods sector of an economy is not necessarily in a position to profit from trade with other nations. The doctrine
of comparative advantage posits that the overall welfare of a nation will
improve if it concentrates on producing goods and services that it can
produce most efficiently, while importing goods and services which can be
produced more efficiently elsewhere. A pre-transition economy may not
be comparatively efficient in the tradable goods sector because a nation
produces many goods and services which it would be better off importing,
while it does not produce goods and services which other nations want to
buy. Alternatively, the pre-transition tradable goods sector might produce
goods and services which other nations wish to import.
However, the doctrine of comparative advantage must ultimately prevail. As a result, a nation with a full-convertibility policy will eventually
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Public Choice Theory and Currency Convertibility
begin to produce in a comparatively efficient manner.9 1 This conversion
to a system of comparatively-efficient production, where a nation quickly
adopts a full or current account convertibility policy, does not come free.
The price is adjustment costs: large segments of the economy must be
diverted to produce different goods and services. The economy as a
whole, as well as individuals functioning in society, must bear the adjustment costs as entire industries are shutdown, jobs are irrevocably lost, and
skills are made obsolete. The amount of the adjustment cost is determined by the configuration of the tradable goods sector of the economy
prior to transition.
If the pre-transition production of goods and services is comparatively
efficient-i.e., the nation already produces goods and services that are
competitive on the world market and imports goods and services that cannot be efficiently produced at home-the adjustment costs will be small
and the benefits from comparative advantage will be large. This is because
the goods and services the country produces most efficiently will be
exported at higher prices than the domestic market is willing to pay, while
the goods and services the country cannot make efficiently will be
imported at a lower cost than if they were produced domestically. On the
other hand, if there is little pre-transition comparative efficiency in the
tradable goods sector, then transition and full convertibility may impose
tremendous adjustment costs. In the short term, the adjustment costs
imposed on the economy as a whole may be so large that the long-term
benefits resulting from full or current account convertibility seem relatively insignificant. Particular industries and other parts of the economy
may have to pay the ultimate adjustment cost: elimination.
The economic theory of regulation provides a model to be used in
evaluating and predicting the configuration of an economy in transition.
Where the pre-transition tradable goods sector is configured to benefit
from comparative advantage, the adjustment costs will be relatively small.
Distributional coalitions, formed from representatives of economic sectors
which stand to benefit from full convertibility, will support politicians who
advocate full convertibility up to the amount of benefits the coalition
would receive under that regime. Coalitions of economic actors in sectors
which will have to pay for full convertibility through adjustment costs will
also form and will expend resources to oppose convertibility. However,
since the pre-transition tradable goods sector is positioned to benefit from
convertibility, anti-convertibility coalitions will be willing to expend considerably fewer resources than pro-convertibility coalitions. This is because
some coalitions will receive more benefits than the costs borne by other
economic sectors.
In particular sectors of the economy, the costs of convertibility may be
very concentrated and the benefits relatively diffused. The marginal costs
91. In the long run, the important but indirect result of current account convertibility is an internationally-competitive tradable goods sector.
note 44, at 93-95.
See Greene & Isard, supra
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to these narrow groups will exceed the marginal benefits which would
accrue to many others. Therefore, the cost-bearing groups will have an
incentive to organize to protect their particular sector, although the marginal costs may not be large enough to provide an incentive to resist convertibility in the nation at large. Although current account convertibility
will progress in the country with the support of those who will benefit
from it, some economic sectors may retain significant government
regulation.
Where the pre-transition tradable goods sector is not well-configured
to benefit from comparative advantage, and consequently the adjustment
costs of a convertibility regime are large, the economic theory of regulation predicts that coalitions in support of convertibility will have less incentive to form. If adjustment costs are large, affected individuals, such as
workers and managers in industries that convertibility would impact
severely, have every incentive to seek information about relevant politicians and proposed legislation implementing a more full-convertibility
regime. Such coalitions will expend resources up to the adjustment costs
of transition in opposition to convertibility. The distributional coalitions
that support legislation implementing convertibility also will have good
reasons to expend resources, but this incentive amount will be relatively
small when compared to that of the opposition coalitions. Politicians acting rationally to maximize their private interests will prefer the greater
resources offered by the opposition coalitions, and full convertibility legislation will fail.
The economic theory of regulation also holds that politicians acting
in their private interests will actively seek out issues where "losers" are not
clearly identified and "winners" are. Politicians may then entice "winners"
to expend resources in the politicians' favor in exchange for support of
the wealth-transferring legislation. Conversely, politicians may also seek to
extract resources from particular industries or markets in exchange for
not imposing transition costs upon them. For instance, in a transitional
nation with severe political and economic instability due to reasons extraneous to convertibility issues, distributional coalitions may not readily
form because the "winners" resulting from a full-convertibility regime may
not be discerned without relatively large organization costs. In essence,
the long-term benefits of convertibility may not be readily attributable to
newly-formed economic sectors. Indeed, the country may be disorganized
to such an extent that the economic actors who would benefit from convertibility are unidentifiable. However, "losers" from full-convertibility
may be identified more easily. These groups will include bureaucrats facing a loss of economic control, state-supported monopolies, and others
who face considerable loss under a full-convertibility regime.
Politicians may seek to extract resources from these groups in
exchange for opposing full-convertibility legislation. The targeted coalitions would be willing to expend resources for the absence of legislation
up to the amount of losses they would experience if such proposals were
approved. In comparison, distributional coalitions in support of such leg-
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Public Choice Theory and Currency Convertibility
islation may not be effectively organized and could not respond to such
tactics by expending their own resources. Conversely, a large country,
even in the face of instability, might present profitable markets to foreign
distributional coalitions if it adopted a current account convertibility
regime which allows access to domestic markets by foreign producers.
These foreign coalitions may be willing to expend significant resources in
exchange for convertibility legislation. 92 If the political environment is
sufficiently unstable to endanger future transfers from coalitions which
oppose current account convertibility, or if the foreign coalitions stand to
benefit significantly from convertibility, politicians will favor convertibility
legislation.
C. Public Choice Theory and the Real Exchange Rate
The real exchange rate measures relative prices between tradable and
nontradable commodities in an economy. In a nation with full convertibility, a weak real exchange rate will raise the price of tradable goods and
services compared to the price of non-tradable goods and services. This
situation will also create an excess supply of tradable goods and services
which may be sold on world markets. Because domestic consumers prefer
cheaper nontradables, there will be excess demand due to the low price
and a reduction in the supply of nontradables as producers shift production resources to exports. The economy will experience a trade surplus.
In addition, there will be domestic wage increases and inflationary pressure within the economy because of the increase in money supply which
follows the trade surplus.
Conversely, if the real exchange rate in a current account convertible
economy is strong, then the price of nontradable goods and services will
be higher than the price of tradable commodities. Producers will respond
by producing more nontradable goods and services and fewer tradables.
Consequently, there will be no excess of tradable commodities to export
and the country will have a foreign trade deficit. Because of the higher
relative price of nontradable commodities, consumers will buy fewer
domestically produced nontradables and more imports. This demand
shift will result in an excess supply of nontradables, which the world market will not absorb. Deflationary pressure within the economy will follow
as demand for the domestic currency decreases. Unemployment will
increase as the production of nontradable commodities diminishes and
the production of exports contracts.
A nation undergoing economic change will experience some unemployment because of the adjustment costs which invariably accompany
transition. If these adjustment costs are combined with unemployment
which follows from a strong real exchange rate, the country may experience very high levels of unemployment and significant economic turbulence. These side effects of convertibility will impose significant costs on
92. Convertibility is all the more significant because it is generally a "one-time" bar-
gain; once convertibility is introduced, it is difficult to undo.
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large numbers of citizens. When those costs exceed the costs of organizing a distributional coalition, coalitions will form to oppose the policies
which have imposed the costs. The economic theory of regulation recognizes that these distributional coalitions will expend resources up to the
level of the imposed costs in order to either redirect the politicians' support or to replace them altogether with other politicians more responsive
to the coalition's interests.
Other distributional coalitions may form to support the strong real
exchange rate. Producers of nontradable commodities will organize to
support a strong real exchange rate which transfers wealth to them. A
strong real exchange rate produces the wealth transfer by increasing the
prices of nontradables. State-supported monopolies and other elements
of a centrally-planned economy can support a strong real exchange rate.
Furthermore, distributional coalitions may form from the tradable sector
to support tariffs and other protectionist policies which protect their
interests from foreign competition.
A transitional country with current account convertibility may choose
to adopt policies which strengthen the real exchange rate. The economic
theory of regulation posits that the question of whether these policies will
be enacted or continued depends upon the costs imposed, as well as the
benefits made possible, by each policy. If the costs are high enough, the
parties who bear them will have every incentive to become informed and
organized to resist the policies which lead to a strong real exchange rate,
and will expend resources to further this resistance up to the amount of
the costs imposed by a strong real exchange rate. Citizens who stand to
benefit from the policies will also expend resources up to the amount of
benefits that the strong rate will transfer to them. The policy adopted
turns upon whether the costs or benefits are greater, as well as the concentration of costs and benefits among the various economic actors. A country-specific analysis is necessary to determine which policy is most likely to
be followed.
Concentration of the costs and benefits is a significant consideration.
The economic theory of regulation holds that individuals are willing to
expend resources to form effective distributional coalitions only up to the
point of their personal cost or benefit from a given policy. If many individuals bear the costs of an unbalanced real exchange rate, then the costs
may be small for each person even if they are large in the aggregate; those
individuals are willing to spend little to organize. However, if benefits are
concentrated, then those who seek wealth-transfers possess the incentive
to spend amounts up to the level of expected benefits to ensure the adoption or continuation of wealth-transferring policies. For instance, unemployment is a diffuse cost; it is large in aggregate while the individual cost
is relatively small. There is an insufficient incentive to form coalitions to
resist policies which increase unemployment. However, a strong real
exchange rate may benefit a relatively small sector of the economy a great
deal, and the recipients of those concentrated benefits will form effective
coalitions to support the strong rate. If, however, unemployment reaches
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Public Choice Theory and Currency Convertibility
cataclysmic levels, the aggregate costs may become so large that individuals with few legal resources to spend in support of favored legislation Will
turn to revolution, assassination, and other extra-legal methods of
influence.
Similarly, a weak real exchange rate in a transitional economy with
current account convertibility generally reduces unemployment but may
increase inflation. A weak exchange rate may ameliorate some of the
unemployment which results from transition adjustment costs. Producers
of tradable commodities will also benefit from the weak real exchange
rate. In contrast, producers of nontradables, as well as various other economic sectors such as emerging capital markets which would be harmed
by increasing rates of inflation, may resist weak exchange rate policies if
the costs become too large. Ultimately, the policy adopted by the politicians will depend upon the absolute level of costs and benefits and upon
their relative degree of diffusion among economic actors.
D.
Public Choice Theory and the Nominal Exchange Rate
The nominal exchange rate is the price of a nation's currency in terms of
another currency. If the country has both current account convertibility
and some elements of capital account convertibility, the nominal
exchange rate may be either fixed, where the government establishes the
currency price, or floating, where the market determines the currency
price.
A fixed nominal exchange rate implies that the nation also restricts
capital mobility.95 A fixed rate also implies that the government is prepared to remedy imbalances in the nominal exchange rate through protectionist intervention in foreign trade. If properly maintained, the fixed
nominal exchange rate induces foreign investment in a nation because the
nation's currency is stable and not subject to large fluctuations in relative
value.
A floating nominal exchange rate is determined by the international
market. While the fixed nominal exchange rate is a governmental policy
which both influences and is influenced by other economic policies and
indicia, the floating nominal exchange rate is purely dependent on other
economic policies, as valued by international currency markets.
Maintenance of a fixed nominal exchange rate requires the government to intervene, or at least be prepared to intervene, in a nation's foreign trade in order to correct current account imbalances. A credible
fixed nominal exchange rate regime may act as a nominal anchor for the
domestic currency, ensuring price stability and attracting foreign investment.9 4 The economic theory of regulation holds that individuals who
stand to benefit from government intervention in foreign trade through
tariffs, import restrictions, and similar measures will organize into distributional coalitions to support an interventionist policy.
93. Greene & Isard, supranote 44, at 98-99.
94. Williamson, supra note 12, at 394-95.
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Other distributional coalitions opposed to protectionist trade measures may organize to oppose the fixed nominal exchange rate scheme.
Their ability to organize and effectively communicate to politicians their
preference for a floating nominal exchange rate for various resources is a
function of the benefits expected from a floating rate, as well as the costs
of trade interventionist policy. Another factor postulated by the economic
theory of regulation is the concentration or diffusion of benefits and costs.
For example, trade intervention may cost many individual citizens a great
deal as prices rise; the cost to any individual citizen, however, is likely to be
relatively small, and this small cost is not enough to rationally justify the
costs of information and organization by trade intervention opponents.
IV. Public Choice Theory as an Explanation for Form and Outcome in
the Transition Process
The 1989 revolutions in Eastern Europe initiated an irreversible process of
change from totalitarianism to political pluralism and representative
democracy. Accompanying this political change is an economic change
from centrally-planned economies to market economies dependent upon
private enterprise, functional pricing mechanisms, and viable currencies. 95 Since political freedom is fundamentally linked to economic freedom, the transition to market economies is one of the most important
issues facing Eastern Europe.
The form of the transition in Eastern Europe cannot be entirely
explained by contemporary economic theory. Public choice theory, however, is the vehicle through which the transition process can best be
understood. Political decisionmakers are certainly influenced by macroeconomic theory; however, even more fundamental than theories which
postulate the most preferable means to effect transition are the economic
realities of public choice, which dictate the nature of the policies actually
implemented.
The form and interim outcome of the transition process are functions
of the costs and benefits of competing transition policies and their aggregate levels of distribution among the economic actors involved with and
affected by the process. There are five groups which may significantly
influence the nature of transition policies: country citizens, politicians,
entrenched bureaucrats, nascent industry, and incumbent industry.
A.
The Economic Actors
1.
Country Citizens
Citizens of a country usually bear the cost of wealth-transferring policies
desired by distributional coalitions, because the costs of wealth-transferring legislation are typically disaggregated and any single citizen must only
pay for a tiny portion of the absolute cost of the legislation. If wealth95. See Domenico Mario Nuti & Richard Portes, CentralEurope: The Way Forward, in
ECoNOMic TRANSFORMATION IN CENTRAL EUROPE 1 (Richard Portes ed., 1993).
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Public Choice Theory and Currency Convertibility
transfer legislation imposes large costs on a readily ascertainable portion
of the public, the cost borne by citizens within the particular group will
increase dramatically. This segregated increase in cost will incite individuals in the targeted groups to organize, seek information, and resist wealthtransferring legislation. For instance, if a particular policy would dramatically reduce government pensions, pensioners would organize to resist this
policy.
Resistance will often coalesce because, in many cases, the costs to citizens resisting a policy may be quite low. For example, it costs relatively
little for a citizen to cast a vote for a rival political party. Information costs,
which can be a barrier to acquiring correct or complete information, may
be very low if the aggregated public group is motivated by an indefinite
principle. An example of this low information cost is when a rival political
party publicly announces that the policies of the majority party would
'hurt' pensioners. Pensioners would then resist the policy, whether or not
it would actually impose excessive costs on them. The information costs of
correcting the rival party's disinformation would not be borne by the pensioners, but by the majority party. This information cost may be too much
for the majority party to meet, and the majority party would lose at the
polls because of "disinformation costs."
2. Politicians
In addition to the general tenets of public choice theory, politicians in
transition countries must consider the possible scope of wealth-transferring legislation. In relatively small countries, information and organizational costs may be significantly less than in larger countries. If these costs
are low, the wealth transfer that may be effected without resistance is considerably less because opposing distributional coalitions will form when
the costs imposed upon individuals by legislation exceed the low information and organizational costs.
When a politician may not rely on significant resource expenditures
for political support by groups which stand to benefit from wealth-transfers, that politician must turn to other sources. In small countries, the
costs of informing citizens may be substantially lower than the costs of
camouflaging wealth transfers. Rather than seeking support from coalitions which stand to benefit from wealth transfers, the politician in a small
transitional country may seek to inform the populace and receive political
support directly from voters.
3. Entrenched Bureaucrats
Entrenched bureaucrats are a legacy of the centrally-planned economy in
countries in transition. They may resist any transition policy that would
reduce the amount of control that bureaucrats may exercise over the
nation. Bureaucrats, just as politicians, broker support in various forms
from groups which could be aided or harmed by policies under their control. Entrenched bureaucrats will resist legislation with higher costs, in the
form of lost control and authority, than benefits.
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Bureaucratic choice is particularly important in nations emerging
from a centrally-planned economy in which the economic decisions made
by entrenched bureaucrats had the greatest impact on the nation. A complex bureaucratic infrastructure cannot be easily dismantled overnight.
The resulting chaos would be less desirable than the previous bureaucratic
inefficiency. Therefore, entrenched bureaucrats in a nation in transition
will retain and defend an important position in the nation's economic
policies.
4.
Nascent Industy
Just as large bureaucracies cannot be dismantled overnight, prosperous
industries generally do not come into existence quickly. The sudden
introduction of private enterprise should cause many small, independent
businesses to start up. However, organizations of nascent industries are
not likely to arise quickly, and there will be a high marginal cost for an
organization to divert its efforts to the legislative arena because there are
no existing organizations. The marginal costs to new enterprises of
becoming informed and organized may, indeed, be prohibitive during
transition.
In contrast, foreign organizations may be willing to expend substantial resources in order to secure legislation which transfers wealth to them.
These organizations do face low marginal costs in that they can merely
divert their rent-seeking efforts from a different country. Domestic politicians will likely have only a very limited ability to extract rent from foreign
enterprises, but foreign organizations may have the resources to influence
substantially the character of domestic legislation.
5. Incumbent Industry
Much like entrenched bureaucrats, incumbent industries once held positions of great importance in centrally-planned economies. Given the
socialist propensity to centralize production, the entire national economy
may have been substantially dependent on the viability of one incumbent
production facility. Furthermore, incumbent industries in centrallyplanned economies absorbed the natural unemployment which market
economies produce; dismantling the incumbent industry may eliminate
employment for an untoward number of citizens.
An incumbent industry may be especially resistant to wealthextracting legislation, not because of its direct efforts or willingness to
expend resources, but merely because substantially affecting the operations of an incumbent may dramatically injure the economy. Politicians
may be unwilling to incur the indirect costs of extracting wealth from an
incumbent industry. The relationship between incumbent industries and
the entrenched bureaucracy is also significant because much of the control which bureaucrats exercised was a result of the industrial configuration of their centrally-planned economy. In essence, incumbent industries
and entrenched bureaucrats constitute a vested coalition, influential
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Public Choice Theoy and Currency Convertibility
beyond its own resources because of the negative economic effect which
would follow its demise.
B.
The Transition Hypothesis
1.
Current Account Convertibility
Theoretically, the most free and successful economy will have full current
and capital account convertibility along with a flexible nominal exchange
rate. In such a hypothetical economy, free domestic or world markets
determine the prices for all commodities and products as well as currency
prices. However, the costs of radically transforming a centrally-planned
economy into a liberal market economy are considerable. Each country in
Eastern Europe will face different costs for various reasons, such as its size
and pre-transition economic configuration. Because of these costs, the
transition process in Eastern Europe has proceeded and will continue to
proceed in ways not explainable by traditional macroeconomic theory.
This nontraditional response is also attributable to self-serving goals of certain groups seeking personal benefits. In addition, because these costs
and benefits vary for each country, transition policies will not be uniform
across Eastern Europe.
Communism demonstrated that autarky does not work. In order to
achieve a successful and dynamic economy, a nation must trade with the
world. Therefore, current account convertibility will be a priority throughout Eastern Europe not only because of economic necessity, but also
because of the link between free trade and political self-determination.
However, the benefits from unrestricted current account convertibility are
diffuse. Specifically, in previously centrally-planned economies, the particular economic sectors which would benefit from policies of unrestricted
international trade are not readily ascertainable. This diffusion of benefits
dramatically increases the organization costs of groups which support liberal trade policies.
In general, it costs very little for citizens to support a politician who
promises "free trade" and access to international markets. Because of
these low costs, politicians who support current account convertibility generally will receive electoral support. This general support does not necessarily encompass the transition policies and legislation which support free
trade.
Specific and detailed legislation is the vehicle through which transition is implemented. The costs to the public of becoming informed and
organized to support specific legislation are considerably higher than the
costs associated with the support of nonspecific principles. These costs act
as a barrier to the disaggregated public becoming informed and organized
to support or resist such policies. However, specific industries and economic sectors will have an incentive to organize and support various policies when the costs of legislation to them are large. While the costs of a
particular current account convertibility policy may be relatively small in
the national aggregate, the costs to a specific industry may be significant.
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That industry has an incentive to transfer resources to politicians up to the
level of costs in exchange for protection and exemption from the policy.
Such sector-specific protections become even more likely because the
centrally-planned economy concentrated many economic sectors. Large
incumbent industries and entrenched bureaucracies are already organized
and concentrated. The marginal costs to these groups of diverting
resources to the political arena are relatively low. Countries in transition,
while ostensibly supporting the principle of free trade through current
account convertibility, will be characterized by protections and exemptons from trade liberalization for incumbent industries and economic sectors organized before transition began.
2. Exchange Rates
A fixed nominal exchange rate implies a commitment by the government
to interfere with the balance of trade in order to maintain the fixed rate.
The government's ability to maintain a fixed exchange rate is also a function of prestige and stability; nations which are capable of maintaining a
stable exchange rate earn a greater level of foreign respect. In addition,
foreign investors look favorably upon stable exchange rates because the
value of their investments in the nation is less likely to evaporate. Politicians benefit from the existence of a maintainable fixed rate because of
the increased influx of foreign capital as well as from increases in domestic
and international political prestige.
The government's commitment to interfere with the balance of trade
in order to maintain the fixed nominal exchange rate is also attractive
because economic sectors will be willing to pay in order to benefit from
restrictive measures. Economic sectors may also be willing to pay for the
harmful regulation of their rivals. Politicians will support a fixed nominal
exchange rate because they can benefit from brokering the succession of
wealth transfers required to maintain the rate. The existence of a fixed
nominal exchange rate also creates a separate real exchange rate, which
the politician can influence through subsidies and favorable tax
treatment.
Nevertheless, because of a multitude of exogenous factors, a strong
commitment to a fixed real exchange rate may be untenable. 96 These
factors may make maintenance of a fixed nominal exchange rate possible
only if the government is capable of dramatically changing the balance of
trade and the real exchange rate. 97 In some cases, the fixed nominal
exchange rate cannot be maintained beyond the immediate term without
throwing the transitional economy into greater economic chaos. Unquestionably, economic chaos is a dramatic incentive for many individuals to
organize to oust politicians from power.
96. SeeAghevli & Montiel, supranote 64, at 208-10. Exogenous factors include spiraling inflation, fluctuations in the exchange rates of major currencies, and insufficient
foreign currency reserves.
97. See id.
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Public Choice Theory and Currency Convertibility
However, transitional countries may be able to maintain a fixed nominal exchange rate in the short term. Because a short-term fixed rate
requires a significant amount of wealth-transferring legislation, from
which various economic sectors stand to benefit, the fixed nominal
exchange rate may be maintained in a country as a vehicle by which
wealth-transferring legislation may be justified. If the economy is large
enough, the short-term benefits to the politicians of orchestrating these
transfers may be sufficient to overcome the prospect of losing office in the
future due to large-scale economic turmoil.
Smaller economies, however, are unlikely to provide the politician the
benefit of large resource transfers in exchange for legislation that effects
immediate wealth-transfers. Because the economy is smaller, the shortterm benefits which the politician could receive are smaller than the benefits which follow from long-term stability and wealth-transferring legislation. Additionally, small economies may present considerably lower
information and organizational costs to individuals. The threshold at
which individuals in smaller economies have an incentive to become
informed and organized to resist certain costly legislative policies is lower,
so distributional coalitions will form more readily than in larger economies. Therefore, flexible nominal exchange rates are expected in small
economies; in large economies, where the possibility of short term
resource transfers to politicians is greater, the fixed nominal exchange
rate will be favored.
C. A Public Choice Analysis of Transitional Policies in Poland
Some form of current account convertibility has been achieved in every
country in Eastern Europe. 9 8 However, capital account convertibility has
not been achieved in most of these countries. 99 No large Eastern European country has implemented full convertibility, which is the unrestricted
ability of citizens and foreigners to exchange the domestic currency for
current and capital account transactions.' 0 0 Eastern Europe is characterized by fixed nominal exchange rates, with the notable exceptions of the
Czech Republic and the Baltic countries. 10 While the paths taken by
Eastern European countries in their transitions to market economies and
democracy have frustrated explanation by traditional economic theorists,
more accurately for the transition differpublic choice theory accounts
02
ences among countries.1
The transition policies in Poland illustrate public choice theory. In
1990, Poland suddenly introduced broad current account convertibility in
98. See INTERNATIONAL MONETARY FUND, EXCHANGE ARRANGEMENTS AND EXCHANGE
RESTRICTIONS (1994) [hereinafter IMF 1994].
99. See id.
100. First Country in Eastern Europe With Full Convertibiliy?, DEUTSCHE BANK RESEARCH,
Feb. 19, 1994, available in LEXIS, News Library, Aliwld File.
101. See IMF 1994, supranote 98.
102. Valtr Komarek, Czech and Slovak Federal Republic: A New Approach, in ECONOMIC
TRANSFOPWATON IN CENTRAL EUROPE 58, 64 (Richard Portes ed., 1993).
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combination with capital account convertibility reforms. This sudden and
radical transformation is called a "big bang." The purpose of this "big
bang" was to radically and permanently improve the quality of the pricing
mechanism in Poland, including interest and exchange rates, and to permanently stabilize these improved prices. 10 3 Between 1979 and 1989, the
Solidarity party forced the Communist government to implement several
economic reform measures. These reforms collapsed, and by 1989 Poland
04
was in economic and political chaos.'
Out of this chaos arose a popular desire for immediate capitalistic
reform. 10 5 However, these reform efforts were not affected by incumbent
or nascent industries. The Solidarity movement made the cost for incumbent industries to influence the revolutionary government too high, and
Poland had an underdeveloped economic sector which stood to profit
from immediate convertibility reforms. As a result, revolutionary zeal, not
distributional coalitions, shaped Poland's transition policies. In exchange
for popular political support, politicians promised efficiency reforms.
Since such reforms incur significant adjustment costs, the politicians, in
order to retain their positions, also promised broader income distribution. 10 6 This policy resulted in deficit spending by the government,
financed by the artificial creation of money. Inflation increased, and real
wages declined precipitously through 1991.107
The transition costs significantly reduced broad popular support for
the principles of immediate reform and thus dampened Polish revolutionary zeal. This significantly reduced the costs to incumbent industries of
wealth transfers through legislative policies. Accordingly, the government
implemented transition policies which favored certain economic sectors.
In early 1991, the Polish government suggested that privatization should
be pursued throughout 1991-92.108 This emphasis did not, however,
result in much concrete action. Of the 8,500 state-owned enterprises in
Poland in 1990, only 52 had been effectively privatized by 1992.109 Poland
has a fixed exchange rate." 0 It also imposes considerable tariffs on
imports, especially industrial consumer products (20%) and agricultural
products and textiles (25%-35%). 111 As a result of these transition policies, Poland experienced a 4% growth in real output in 1993, largely concentrated in industrial and agricultural output.112 Annual inflation has
103. Stanislaw Gomulka, Poland: Glass HalfFull in ECONOMIc TRANsFoRMATION IN
CENTRAL EUROPE 187, 190 (Richard Portes ed., 1993).
104. Id. at 187-89.
105. See id. at 188.
106. OrderDisguised as Chaos, THE ECONOMIST, Mar. 13, 1993, at 4.
107. Real industrial wages fell by 41% through 1991. Id. See Gomulka, supra note
103, at 193-96.
108. Dariusz K. Rosati, Poland: Glass Half Empty, in ECONOMic TRANsFORMATION IN
CENTRAL EUROPE 211, 234 (Richard Portes ed., 1993).
109. See id.
110. Stabilization,Reform, and the Role ofExternalFinancingin the Countries in Transition,
International Monetary Fund, May, 1994, available in LEXIS, News Library, Allwld File.
111. IMF 1994, supra note 98, at 400.
112. See generally Stabilization, supra note 110.
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Public Choice Theory and Currency Convertibility
been reduced by 35%.11
The Polish experience illustrates the basic applicability of public
choice theory to countries in transition to market economies. A distributional coalition will organize to support wealth-transferring legislation
when the benefits of that legislation to the coalition exceed the costs of
organizing and supporting it. In Poland, when the costs to incumbent
industries of supporting favored legislation became excessive because of
backlash against the communist regime, uninformed popular ideology
guided legislation. This result occured because the costs to the public of
supporting radical reform were significantly less than the costs of the previous economic configuration. When the costs of reform to the public
exceeded benefits, support dissipated. Incumbent industries, no longer
encumbered by popular political costs, supported and enabled legislation
which restrained radical transformation and replaced it with measured
protectionism and favors. The overall effect of this process is substantial
progress in transition combined with substantially greater economic stability and expansion. Public choice theory is not entirely descriptive. Just as
microeconomic actors who act in their own rational self-interest are the
basis of the success of a market economy, economic and political actors
who act in their own rational self-interest are, in the aggregate, most able
to construct the foundation upon which a market economy is built.
Conclusion
The process of transition to a market economy from a centrally-planned
economy is not a simple or inexpensive task. The application of public
choice theory to this process cannot alleviate the pains of change. However, public choice theory does rationalize this process. Rather than viewing transition policies as sometimes inexplicable conglomerations of
sometimes questionable economic theory, this Article has introduced a
framework under which transition policies are analyzed as the results of
rational decisions made by self-interested actors.
Eastern Europe is, by any definition, far from homogenous. These
sometime spectacular differences account for the considerable lack of
overarching macroeconomic theories to predict and guide transition. The
fundamental inquiries in the public choice analysis are the cost and benefit possibilities which each political and economic actor faces; the theory
cannot determine the possibilities that these actors should face. Because
of this mutable characteristic of public choice theory, it is readily adaptable to the different circumstances in each transitioning nation.
Public choice theory as applied to the transition process in Eastern
Europe is valuable as a descriptive tool. It is also valuable as a normative
principle. A market economy relies upon untold numbers of economic
decisions to function. These decisions are made by individuals, acting in
their own rational self-interest. This principle characterized the 1989 revo113. Id.
416
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lutions: the freedom to choose. Public choice theory reveals these
rational transition decisions, and posits that the ultimate result of individual self-interest is collective efficiency and well-being.